For a long while on this blog I’ve somewhat avoided discussing why I’ve invested in a particular stock partly because in some cases I really didn’t have a good reason for buying it in the first place. My very first stock I picked way back when I was a teenager, I picked because I liked the name. Sad, but true. That changed in the last year when I took a class on basic accounting that helped me focus on how to decode a balance sheet from a company. Now I’m skimming some fairly damn specific data before I buy a stock which I would like to share with you.
In terms of investor types I would typically fall into the value or income investor. So please do keep that in mind while reading this series. If you have other goals you might end up looking at other factors.
Step 1 – Define Goals
Step one for me is to look at what businesses tend to have a long term profit and also tend to issue dividends. I don’t buy stocks for growth. I’m after a nice stream of cash from a business and if I get a lot of growth, well that would be nice, but frankly I’m not counting on it most of the time. So that tends to limit myself a fair bit on businesses, as I avoid start ups and IPOs are also off the table. Both tend to be high risk ventures with no defined pay out.
As to what sectors I buy into I tend to look for companies that have repeat business on a monthly basis. That way they have a nice stream of cash coming in to help pay me off in dividends. So what companies are a good idea? Look at the bills you pay monthly: water & sewer, electricity, phone and internet, bank fees and mortgage, natural gas to heat your home and gas for your car. Based on those you look for utilities, telecom, banks (and/or Real Estate Income Trusts if you rent), oil and gas companies.
Step 2 – Determine Level of Risk
Unlike a lot of people who think the stock market is a great thing, I tend to think of it as highly risky. It’s subject to mass panic, speculation and rumor to define what your portfolio is worth on a given day. So I did my research and came to an interesting conclusion: you don’t need as much risk as you think. It is possible to have a portfolio that is only 20% stocks that can still beat inflation (based on average return data from 1950 to 2007). This isn’t to say you can’t have 100% in stocks, it all depends on your skill set and you comfort level.
In my case I’m planning on about 25% of portfolio in stocks. Why so low? Well in a nut shell my low expenses are a double edge sword, yes I get to retire early because of it, but on the other hand I don’t have a tonne of fat left in the budget. I can’t afford to have massive drops in the portfolio if I had a 100% in stocks, so I aim lower and accept that I will be doing some work during my retirement years as a backup.
Step 3 – Find the Unloved
People screw up, it happens. What is particularly interesting is when companies or governments screw up? Why? Because panic and fear can be an investors best friend when looking for value. I’ve seen it numerous times when people over react to some news and you end up with a really low share price and high yield. I tend to look at news report of ‘the sky is falling’ to equal ‘let’s go shopping’. Sort of like the last week or so is getting me scanning companies again seeing where some of my watch list is at.
A decant way to shift through a series of companies on most stock screeners is to use the P/E ratio. Which is the stock price divided by the earnings per share of the company. The lower the ratio indicates a depressed stock price. A P/E of 20 is ok, but a P/E of 10 is ‘oh my god, what the hell happened to you to get crushed’ which means I would look into it further. A good way to think of P/E is the number of years of earning per share earnings you would have to get in order to pay back your original purchase stock price. It’s not like you would want to ever get a 100% of the earnings as a dividend, but it makes the ratio a little bit more easier to understand.
A similar method of looking for the unloved is to skim stocks by yield (how much of dividend are they paying divided by share price expressed as a percentage) . The higher the yield the more likely the P/E is going to also be lower. Just keep in mind…it it looks to good to be true, you might find a surprise in the financial reports.
Next up in the series – after you have found an unloved company, I’ll show you what I look for in its financial statements.
So what do you do differently when you start looking for a stock to buy? Any tips or ideas to share?